Big investors, such as foreign institutional investors (FIIs) and domestic institutional investors (DIIs), invest heavily in stock markets around the world. Their capital helps to keep the markets liquid, but they are also exposed to a significant risk of loss whenever the market falls. So, how do they manage this downside risk and stay invested without worrying?
Futures and options are derivative instruments of choice when it comes to saving oneself from the ire of market downturns. In this blog we will find out what are futures and options and how to use them to save yourself from losses when the markets are going against you.
What are derivatives?
Before we go any further, let us introduce you to the concept of derivatives. These are instruments that derive their value from an underlying asset. These assets can be stocks, commodities, bonds, and any other tradable instrument such as cryptocurrencies.ย
There are two types of derivatives which are generally used by market participants to save their existing open positions, futures and options.
Let us now see how these two types of derivatives can help you navigate the markets with safety.
What are futures?
Futures are a type of derivative contract that obligates the buyer to purchase or the seller to sell an asset at a predetermined future date and price. The asset can be anything that can be traded, such as stocks, commodities, bonds, or even cryptocurrencies.
Here is a simple example of a futures contract:
A farmer and a cereal company agree on a futures contract to sell wheat at โน5000 per bushel in 6 months.
If the price of wheat goes up to โน6000 per bushel in 6 months, the cereal company will still only have to pay โน5000 per bushel, because of the futures contract.
If the price of wheat goes down to โน4000 per bushel in 6 months, the farmer will still be able to sell their wheat for โน5000 per bushel, because of the futures contract.
Futures contracts are traded on stock exchanges, and they are used by a variety of market participants, including traders, businesses, and investors.
In stock markets, futures contracts are generally traded in LOTS where the lot size depends on the price of the underlying stock. Here are a few examples of futures contracts and their lot sizes from Indian listed companies.
| SECURITY NAME | SYMBOL | LOT SIZE |
| IDFC First Bank Limited | IDFCFIRSTB | 15,000 |
| Maruti Suzuki India Ltd. | MARUTI | 100 |
| Vodafone Idea Limited | IDEA | 80,000 |
| Atul Ltd | ATUL | 75 |
| GMR Airports Infra Ltd | GMRINFRA | 22,500 |
Source: NSE
What are options?
Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. The underlying asset can be a stock, index, commodity, or other financial instrument.
Simply said, Options are like insurance contracts for stocks, commodities, or other financial assets.
For example, you could buy a call option on a stock if you think the stock price is going to go up. If the stock price does go up, you can exercise the option to buy the stock at the strike price, which is the price that you agreed to pay for the option. This way, you can lock in a profit on the stock price increase.
If the stock price does not go up, you can simply let the option expire and lose the premium that you paid for it. This is why options are called “options” and not “obligations.” You only have to exercise the option if you want to.
Types of Options
There are two main types of options: calls and puts. Let us now understand more about them-
Call options:
A call option gives the buyer the right to buy the underlying asset at the strike price on or before the expiry date.
Lets understand this with an example.
Imagine that you are bullish on the stock of Reliance Industries which is currently trading at โน2,800. You believe that the stock is going to go up in price in the next 3 months. To speculate on this view, you could buy a call option on Reliance Industries with a strike price of โน2,800 and an expiry date of 3 months.
If the price of Reliance Industries stock goes above โน2,800 in the next 3 months, you can exercise the call option to buy the shares at โน2,800. This way, you can profit from the rise in the price of the stock and pocket the difference between the future price of stock and the premium paid.
If the price of Reliance Industries stock does not go above โน2,800 in the next 3 months, the call option will expire worthless and you will lose the premium that you paid for the option.
Put options:
A put option gives the buyer the right to sell the underlying asset at the strike price on or before the expiry date.
Imagine that you are bearish on the stock of Tata Consultancy Services (TCS) which is currently trading at โน3500. You believe that the stock is going to go down in price in the next 3 months. To speculate on this view, you could buy a put option on TCS with a strike price of โน3,500 and an expiry date of 3 months.
If the price of TCS stock falls below โน3,500 in the next 3 months, you can exercise the put option to sell the shares at โน3,500. This way, you can profit from the fall in the price of the stock and pocket the difference between the future price of stock and the premium paid.
If the price of TCS stock does not fall below โน3,500 in the next 3 months, the put option will expire worthless and you will lose the premium that you paid for the option.
Conclusion
Although the topic of futures and options is a vast one and needs much more detailed analysis for better understanding of these products. We hope this blog has helped you in understanding the basics of these instruments and how to use them under different market scenarios for hedging your portfolio against drawdowns.
FAQs
Futures contracts are agreements to buy or sell an underlying asset at a specified price on a future date. Futures contracts are traded on exchanges, and they are used to hedge against price fluctuations in the underlying asset.
Options contracts give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. Options contracts can also be used to hedge against price fluctuations in the underlying asset.
The main difference between futures and options is that futures contracts are binding, while options contracts are not. This means that if you buy a futures contract, you are obligated to buy or sell the underlying asset at the strike price on the expiry date. If you buy an options contract, you have the right, but not the obligation, to buy or sell the underlying asset at the strike price on or before the expiry date.
Futures and options trading is not suitable for
everyone. It is important to understand the risks
involved before you start trading futures or
options. You should also have a good understanding
of the underlying asset and the markets in which you
are trading.
If you are new to futures
and options trading, it is a good idea to start with
a paper trading account. This will allow you to
practice trading without risking any real money. You
should also consult with a financial advisor before
you start trading futures or options.
There are several benefits to trading futures and
options, including:
Hedging: Futures and
options can be used to hedge against price
fluctuations in the underlying asset. This can be
helpful for investors who are long or short the
underlying asset.
Speculation: Futures
and options can also be used to speculate on the
future direction of the price of the underlying
asset. This can be a way to make profits if the
price of the underlying asset moves in your
favor.
Leverage: Futures and options are
leveraged instruments, which means that you can
control a large position with only a small amount of
money. This can amplify your profits, but it can
also amplify your losses.
Futures and options are complex instruments, and
they carry a number of risks, including:
Leverage:
As mentioned above, futures and options are
leveraged instruments. This means that you can lose
a lot of money if the market moves against you.
Price
volatility: Futures and options can be highly
volatile, which means that their prices can
fluctuate wildly. This can make it difficult to
manage your risk and to make profits.
Counterparty
risk: When you trade futures or options contracts,
you are entering into a contract with another party.
If this party defaults on their obligations, you
could lose money.
